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Page 1: Copyright © Houghton Mifflin Company. All rights reserved.15 | 1 Monetary Policy Chapter 16

Copyright © Houghton Mifflin Company. All rights reserved. 15 | 1

Monetary Policy

Chapter 16

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• What is the Federal Reserve?– The “Fed” is the central bank of the United

States…It oversees many financial institutions and ensures the continued efficient functioning of the payments system

– Comprised of three main parts• The Federal Reserve banks• The Board of Governors• The Federal Open Market Committee (FOMC)

The Federal Reserve System

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• System is headed by the Board of Governors

• The twelve Federal Reserve banks are located throughout the nation

• U.S. monetary policy is determined by the FOMC

The Federal Reserve System (cont’d)

Figure 15.1 The Structure of the Federal Reserve System

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• The Board of Governors– The Federal Reserve System is overseen by the seven-member Board of

Governors of the Federal Reserve. Actions taken by the Federal Reserve are called monetary policy.

• Federal Reserve Districts– The Federal Reserve System consists of 12 Federal Reserve Districts, with one

Federal Reserve Bank per district. The Federal Reserve Banks monitor and report on economic activity in their districts.

• Member Banks– All nationally chartered banks are required to join the Fed. Member banks

contribute funds to join the system, and receive stock in and dividends from the system in return. This ownership of the system by banks, not government, gives the Fed a high degree of political independence.

• The Federal Open Market Committee (FOMC)– The FOMC, which consists of The Board of Governors and 5 of the 12 district

bank presidents, makes key decisions about interest rates and the growth of the United States money supply.

Structure of a Federal Reserve Bank

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Banks provide many services• Check clearing services• Supervision and examination of member

banks• Track banking statistics and monetary

aggregates• Supply currency and coin to member

banks• Serve as fiscal agent of the U.S. Treasury• Act as a lender of last resort

Federal Reserve Banks

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The locations of the 12 banks are a reflection of the political power structure of 1913 and are spread out to diffuse power

The Federal Reserve System

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The Federal Reserve System

Figure 15.3 Board of Directors of a Federal Reserve Bank

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• The Board is more like a government agency than the banks, and subject to more scrutiny

• Each member is appointed by the President to a 14 year term which is not renewable– 7 governors serve– One member’s term expires every 2 years– Can stay more than 14 years if appointed to less-

than-full term initially

• Chairman of the Board of Governors is second most-powerful position in U.S. after President

The Board of Governors

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• Chairman & Vice-Chairman are appointed by the President to renewable 4-year terms

• Chairman wields tremendous power– Measure Chairman’s success by the

inflation rate, the only economic variable the Fed can control in the long run

– Effects of monetary policy are short-lived

The Board of Governors (cont’d)

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The Federal Open Market Committee

• When the press discusses the Fed, their focus is generally on the Federal Open Market Committee (FOMC).– This group sets the interest rates to control the

availability of money and credit to the economy.– It has existed since 1936 and has 12 voting

members:• The seven governors,• The president of the Federal Reserve Bank of

New York, and• Four Reserve Bank presidents.

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The Federal Open Market Committee• The chair of the Board of Governors chairs

the FOMC.• The committee’s vice chair is the president

of the Federal Reserve Bank of New York.• While only 5 of the 12 Reserve Bank

presidents vote at any one time, all of them participate in the meeting.

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The Federal Open Market Committee

• The FOMC could control any interest rate, but it chooses to control the federal funds rate.– This is the rate banks charge each other for

overnight loans on their excess deposits at the Fed.

• By controlling the federal funds rate, the FOMC influences real growth.

• The FOMC currently meets 8 times a year.• The primary purpose of a meeting is to decide on

the target interest rate.

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Responsibilities of the Fed

• Maintaining the currency (currency & coins)

• Maintaining the payments system (online banking & check writing)

• Regulating and supervising banks (FDIC & bank holding companies)

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Responsibilities of The Fed

• Financial literacy and consumer protection (Consumer Financial Protection Bureau)

• Acting as the government’s bank (financial services)

• Conducting monetary policy

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The Path of a Check

Check writer Recipient

The check is then sent to a Federal Reserve Bank.

Federal Reserve Bank

The reserve bank collects the necessary funds from your bank and transfers them to the recipient’s bank.

Check writer’s bankYour processed check is

returned to you by your bank.

The Journey of a Check• After you write a check,

the recipient presents it at his or her bank.

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Copyright © Houghton Mifflin Company. All rights reserved. 15 | 16THE MONETARY SYSTEM 16

Bank Reserves• So far we have been assuming that banks hold the entire

amount of their deposits in reserve.• Clearly this is a false assumption as banks rarely ever

have enough currency in their vaults (or on reserve at the Fed) to cover all deposits made with them.

• The banking system operates as a fractional reserve system in which only a portion of the banks deposits are held in reserve.

• The Fed sets a lower limit for the fraction of deposits that must be held in reserve: the reserve requirement ratio

• Since banks earn profit by lending at higher interest rates than they give on deposits, the reserve requirement is generally a binding limit.

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• The Fed requires banks to keep a minimum amount of required reserves.– Required reserves – The minimum amount of

reserves a bank is required to hold; equal to required reserve ratio times transactions deposits.

– The fed directly alters the lending capacity of the banking system by changing the reserve requirement.

Reserve Requirements

Required reserves = required reserve ratio X total deposits

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* By changing the reserve requirement, the Fed changes the level of excess reserves in the banking system.

Reserve Requirements

Excess reserves = Total reserves – Required reserves

* Excess reserves are bank reserves in excess of required reserves.

* By raising the required reserve ratio, the Fed can immediately reduce the lending capacity of the banking system.

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Open Market Operations

• The main “thing” the Fed buys and sells is U.S. government securities, which are bonds the government originally sold to investors when it needed to borrow funds.

• The Fed buys and sells such securities in the financial market, it is said to be engaged in open market operations.

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Open Market Purchases

• Consider an open market purchase of government securities by the Fed.

• The Fed receives the securities from a bank, and the bank’s reserves increase by the amount the purchase (remember Reserves = Bank deposits at the Fed + Vault Cash).

• When the banks have a reserve increase and no other bank has a similar decline, the money supply expands through a process of increased loans and checkable deposits.

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Open Market Sales

• Open market sales refer to Fed sales of government securities to banks and others.

• In one of these sales, a bank buys securities from the Fed and the money is taken from the reserves of the bank.

• This decreases the money supply by having the bank reduce total loans outstanding, which reduces the total volume of checkable deposits and money in the economy.

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Open Market Operations

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Monetarism is the belief that the money supply is the most important factor in macroeconomic performance.

How Monetary Policy Works

The Money Supply and Interest Rates• The market for money is like

any other, and therefore the price for money — the interest rate – is high when the money supply is low and is low when the money supply is large.

Interest Rates and Spending• If the Fed adopts an easy

money policy, it will increase the money supply. This will lower interest rates and increase spending. This causes the economy to expand.

• If the Fed adopts a tight money policy, it will decrease the money supply. This will push interest rates up and will decrease spending.

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The discount rate is the interest rate that banks pay to borrow money from the Fed.

Discount Rate

Reducing the Discount Rate• If the Fed wants to encourage

banks to loan out more of their money, it may reduce the discount rate, making it easier or cheaper for banks to borrow money if their reserves fall too low.

• Reducing the discount rate causes banks to lend out more money, which leads to an increase in the money supply.

Increasing the Discount Rate• If the Fed wants to discourage

banks from loaning out more of their money, it may make it more expensive to borrow money if their reserves fall too low.

• Increasing the discount rate causes banks to lend out less money, which leads to a decrease in the money supply.

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Policy lags are problems experienced in the timing of macroeconomic policy. There are two types:

Policy Lags

Inside Lags• An inside lag is a delay

in implementing monetary policy.

• Inside lags are caused by the time it actually takes to identify a shift in the business cycle.

Outside Lags• Outside lags are the time

it takes for monetary policy to take affect once enacted.

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The Federal Reserve must not only react to current trends, but also must anticipate changes in the economy.

Monetary Policy Dilemmas

Monetary Policy and Inflation• Expansionary policies

enacted at the wrong time can push inflation even higher.

• If the current phase of the business cycle is anticipated to be short, policymakers may choose to let the cycle fix itself. If a recession is expected to last for years, most economists will favor a more active monetary policy.

How Quickly Does the Economy Self-Correct?• Economists disagree about

how quickly an economy can self-correct. Estimates range from two to six years.

• Since the economy may take quite a long time to recover on its own, there is time for policymakers to guide the economy back to stable levels of output and prices.

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Changing Nature of Economics

• Discretionary fiscal policies were popular in the post-World-War II period, but their popularity declined after President Reagan took office.

• The Federal Reserve System has filled the void left by the decline of discretionary fiscal policy.

• The Fed is much more responsive to economic issues than the federal government.

• Supply-side policies have been popular, but they did little to help when the economy slumped in 2008.

• Policies used to stabilize the economy during the Great Recession included monetary policy, qualitative easing, and passive fiscal policies.

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Economics and Politics• In recent years, the fields of economics and politics have

merged.• The main reason for differences of opinions among

economists is that they place different importance on various problems.

• Most economic theories are a product of their times; as times and issues change, so does economic theory.

• The president’s Council of Economic Advisers is a three-member group that reports on economic developments and proposes strategies.

• Economists have helped the American people become more aware of the workings of the economy, which benefits everyone.